Thursday, February 17, 2011

Going Broke on $250,000 a year.

Yes Virginia, you can go broke while making a quarter-million a year.  And you do it the same way a fellow making only $50,000 a year does - spend faster than you make it.

A reader asks: "What should my net worth be if I make a salary of $250,000 a year?"

The answer is "a lot" but depends on how old you are and how long you've been making that much money.  The vaunted "net worth equal a year's salary at age 30" might not make sense if you just became a doctor, and spent years in medical school and training, and have staggering student loan debt and are just now, at age 30, making "big money".

On the other hand, if you have been making this kind of dough for a decade or more, you should be worth millions - or at least a million.

Surprisingly, few are.  And this is a shame.  Why on both counts?  Let's explore.

With regard to the latter, it is a crying shame, as if you are making that kind of money, you have the opportunity to build dynastic wealth, and yet most squander it, like the couple above, on a fancy house and depreciating assets - high end cars.  It is doubly a shame as that sort of income is not guaranteed for life.  Oftentimes, events occur, usually in the mid-50's, that put a screeching halt to the money train, and bad things pile up in a hurry.

I know a lot of bitter, old people who will, after a few drinks, tell you what a high roller they "used to be" back in the day, but now at age 65 they are nearly broke.  And this needn't have been, if they had put a little aside early on, rather than trying to live up to their salary expectations.

So how do you go broke on $250,000 a year?  It ain't hard to do.  As I noted in my "Going Broke on $100,000 a year" posting, the simple answer is to spend more than you make.  And I have used the example of my Attorney friend, now deceased, who lived the large lifestyle on a six-figure income, with the look-at-me house, the fancy cars, and the country-club membership.  He thought it would go on forever, but when he died, it turned out it was all financed, and that his net worth was zero, and within months, his widow and infant son were destitute.

So, where does a quarter-million dollars go?  As I noted in one of my tax postings, a lot goes to Uncle Sam and your State.  The nice thing is, our tax system actually favors people making more than $100,000 a year, as they pay no Social Security tax on income above about $108,000.  But nevertheless, expect to pay about 1/3 of your income in taxes, between Federal, State, Social Security, and Medicare.

So, right off the bat, $250,000 becomes $160,000 in a real hurry.  And if you are earning that money on a salary, you are paying the highest taxes possible.  So right off the bat, you call an Accountant and ask them how to reduce your tax burden.

And since the Accountant is not a Genie, all he can do is suggest the usual tax tricks - home mortgage interest deduction, or perhaps using an investment property to convert ordinary income into capital gains.

So, our intrepid friend goes out with the wife to buy the biggest and ugliest mini-mansion possible, as the Accountant suggests that the interest on the mortgage is tax-deductible and will "reduce your taxes".  Funny how someone can be smart enough to make $250,000 a year and still be dumb enough to fall for that line of reasoning.

You can't deduct your way to wealth just as you can't eat your way to slimness.  Spending less is the key to accumulating wealth, not spending more.  But our friend, convinced he is making a sound investment - using the IRS tax code as his investment guide, goes out and buys a 1.5 million-dollar home, which has a mortgage payment of over $7,500 a month, or $90,000 a year.  While he may have cut his taxes by $30,000, he has put a real dent in his cash flow.  And the savings in income taxes are pretty much offset by the cost of property taxes on such a home, plus the insurance.  So from a tax perspective, it is a net wash.

So, his $160,000 a year is now down to $70,000 a year.  Just taxes and mortgage payments have cut his salary by 3/5ths.

But of course, he and the wife feel they deserve new cars - preferably every three years by leasing.  And of course, on his salary, Nothing but the best Mercedes or BMWs will do - or even more esoteric marques like Bentley or Maserati (as shown above) or Jaguar.  They can spend, with lease payments and insurance, easily $1500 to $2000 a month on car payments, between the two of them, particularly since our friend likes to speed, and his insurance is astronomical.

So we're down to $46,000 a year now.  Still a lot of money, right?  Well, throw in all the cable channels and a premium cell phone family plan - we have to have the latest iPhones, right? - and of course XM radio and other subscription services, and we're taking $400 a month or more.  So that drops our income to $41,200.

And there are the cost of groceries and eating out.  I easily spend $1000 a month on this, but if you have one of those high-paying, long hour jobs, chances are, you are eating out for lunch every day, and "too tired" when you get home, and so sending out for take-out or going out to dinner.  So we could be talking $2000 a month, easily.

Our $250,000 income is down to $17,200.  The Accountant calls and suggests you contribute to your 401(k) plan.  Too late, you realize that you need to be saving for retirement.  So you try to sock away $20,000 in the 401(k) plan - a pitiful amount for someone making $250,000 a year - and your income goes negative at this point.

But hey, you're "rich", right?  Making good money?  So, just put some of those expenses on a credit card.  You've got a great credit score!  And that must mean you are financially astute. 

Of course, that mini-mansion doesn't furnish itself, and with the wife staying home all day long, she has little to do, other than take her aggressions out on shopping, to the tune of thousands a month.  And of course, since you are "rich" you deserve that vacation in Vegas, right?  And it's tax-deductible as a business expense, so it must be a smart thing to do, right?

So the credit card debt starts to climb, higher and higher, and our intrepid friend doesn't worry because he's making $250,000 a year and anyone who makes a good salary is a rich man.

Right?  Right?

Wrong.

It doesn't matter how much you make, if you spend more than you make, you are poor - and going into debt.  And what is really sad is that people do this, and then wonder "where all the money went".

Now, some of you may accuse me of fudging the numbers here - of making up a scenario that is too fantastic to believe.  Because no one in their right mind making $250,000 a year would squander money in this way, right?  Right?

Wrong.

The scenario described above describes a couple I know (or knew).  They had over $50,000 in credit card debt, massive monthly car payments, huge expenses from "living large" and bought an outrageously overpriced home on one of these dubious financial instruments.  And of course, it all fell apart when the recession came.

What mistakes did they make?  A ton.  Where to start?  Well, here goes.

1.  Never use the IRS tax code as an Investment Guide:  Deductions are fine and all, but you can't deduct your way to wealth.  They bought too much house, no only because they thought they "deserved it" and wanted Status, but because they thought it was astute financial planning to get as big a deduction as possible.  And a lot of financial and tax gurus preach this nonsense.  A smaller, more reasonable house would have allowed them to save more (max out that 401(k)) and live on less.

2. You are never too rich to cut expenses:  When you start to make six figures, you assume (wrongly) that you need not worry about money so much.  A dollar here, $10 there, $100 there, it is chump change compared to the "big money" you are making - and you can always make more, right?  Wrong.  You can get laid off on a moment's notice, and if you spend all your disposable income on take-out pizza and cable TV, well, too bad for you.

3.  The Road to Middle Class Poverty is Paved with Car Payments:  A big chunk of their disposable income goes to car payments and insurance.  While a brand new Mercedes every three years is nice, it is also nice and expensive.  And these are the kinds of cars that easily last a decade or more - and are timeless in their styling.  So why not take advantage of their tank-like construction and keep them?  Saves a lot of money, and you can still have your status.

4.  Not Paying Yourself First:  Before spending on a house, car, and other junk, max out your savings on that 401(k) and also set up a savings plan for after-tax income (the money you will live on when you are laid off or can't work for some reason).  THEN, spend what you have left over.  Buying toys for yourself first and then trying to save is bass-ackwards.

5.  Not Monitoring Net Worth:  Spending money based on the salary-man mentality - dividing up the paycheck into a monthly cash-flow of payments to creditors - is idiotic at any income level, criminal at six figures and above.  If you spend this way, you are not looking at the actual cost of many of these items in terms of how they affect your net worth - and as a result can easily go further and further into debt over time, or at the very least, not increase your net worth as you should.

So, what's the downside for our friend?  In the worst case scenario, he ends up bankrupt on $250,000 a year, and yea it happens.  Or he loses the "dream job" for one reason or another and ends up destitute.  At best, he realizes later in life (age 50) that he should have been spending less and saving more, and figures out that his retirement years are going to be a lot bleaker than they should be, because he spent on junk instead of saving first.  He scrambles to put aside money in his later years, realizing that the benefits of compound interest are no longer working in his favor.

And how do I know this?  Well, this latter scenario describes my situation, to some extent.  I never made the fabled $250,000 a year - well, I came close to it, anyway.  But those days are gone, as the Patent Business has gotten more competitive and less lucrative (and as I work less, too).  I was smart enough to sock some money away, but not as much as I probably should or could have.  I felt, like many people in their 30's and even 40's that saving was something I could do later on down the road.

If you are making "good money" but still don't seem to be able to "get ahead", maybe TODAY is the day to re-think your priorities.  You can have a wealthy lifestyle without squandering a lot of dough.  It just takes some effort and thought and a rearrangement of your priorities.

Because no one will feel sorry for you if you go broke on $250,000 a year.

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